A New Look at Insider Trading and Performance

Keywords: Insider trading

Abstract
The insider trading literature finds that insiders have trade timing ability based on studies of stock returns in the period surrounding insider trades. While this finding suggests insiders generate abnormal returns, it ignores the impact of their initial holdings and trading frequency. In this study, we estimate the abnormal total return that insiders generate over the period from their first to last reported trade. We show that insiders are generally buy-andhold investors in their own companies. Insiders retain an average (median) of 67% (84%) of the shares they accumulate. While insiders earn on average abnormal total annual return of 1.37%, the median is -1.16%. Thus, the typical insider does not beat the market. While there is substantial variation in abnormal returns earned by insiders, little of this can be explained by insiders relationship to the company, their position with the company, the size of their holdings, their trading pattern or the size of their company.

A New Look at Insider Trading and Performance 1. Introduction

This paper has three goals: 1) to measure the abnormal return earned by insiders on their holdings of the companys shares during their tenure as an insider; 2) to provide evidence on the actual buying and selling patterns of insiders; and 3) to compare the returns and timing of different insiders. The primary purpose of this study is to measure insiders abnormal total return in a way that takes account of their holding period returns rather than just the traditional approach of measuring returns around insider trades. Given the advantage of their asymmetric information, insiders are in a position to generate abnormal returns. They may do this by choosing to trade or by choosing not to trade on the basis of this information. As an example of the latter, a CEO who knows his company will report unexpectedly positive earnings can choose not to sell his shares. In this case, he is using his superior information to enhance returns even though he is not trading (this decision, even if based on undisclosed material information, is not illegal). Thus, it is important to consider the returns that insiders earn when holding the stock and not just when they are trading. Trading on undisclosed material information is illegal in the U.S. and Canada. This drives a natural interest in measuring abnormal returns around insider trades. Previous studies have done just that. They measure returns around purchase and sale transactions (e.g., Jaffee (1974), Finnerty (1976), Seyhun (1986), Eckbo and Smith (1998) and Jeng, Metrick and Zeckhauser (2003)). This methodology can be a proxy for a total return if abnormal returns are concentrated in the short-term periods around trades. If not, then abnormal returns measured around trades paint an incomplete picture of insider performance. In this paper we calculate a new measure which is a complete summary of insider trading performance from their first recorded trade to their last. Henceforth, we refer to this more comprehensive measure of performance as the insiders total return. We use a new insider trading data set from the Toronto Stock Exchange 1

that allows us to track individual insider initial holding and subsequent trading activity over an 18 year period. The insiders total return is of interest to outside investors since positive abnormal returns come at their expense. Furthermore, the total return is of interest to finance academics because evidence of persistent positive abnormal insider returns is consistent with the hypothesis that insiders exploit their asymmetric information. A secondary purpose of this study is to provide some evidence on the actual buying and selling patterns of insiders. We show that insiders are generally buy-and-hold investors in their own companies. Insiders retain an average (median) of 67% (84%) of the shares they accumulate. Over a holding period of approximately 4 years, the insiders trade on an average (median) of 10.5 (5.0) days. The high retention of stock and the relatively infrequent trading suggest that measurement of insider returns should take account of the holding period rather than just the periods of trading. Our estimates suggest that, on average, insiders do not earn abnormal total returns (the average insider earns a small positive abnormal return but the median insider earns a small negative return). The measures of central tendency mask huge variation across the sample. For example, the top-third of insiders earn very large abnormal total returns (this group averages over 33% abnormal total return). While there is substantial variation in abnormal total returns earned by insiders, little of this can be explained by insiders relationship to the company, their position with the company, the size of their holdings, their trading pattern or the size of their company. As a complement to the total return measure, we conduct the traditional tests of insider trading performance with the buy-and-hold approach and the calendar portfolio approach used in Jeng et al (2003) and Loughran and Ritter (1995). The results of both of these tests suggest that the buy timing of insiders on the Toronto Stock Exchange is poor but their sell timing is excellent. The buy-and-hold approach shows a mean abnormal return in the one year prior to (post) buys equal to -1.3% (-4.4%). The mean abnormal return prior to (post) sells equals 35.0% (-7.3%).

The third purpose of the paper is to examine whether our proposed measure of abnormal total return and traditional measure of insider timing ability vary across insider categories (relationship and executive position). The paper tests the information hierarchy hypothesis: whether the insiders with the greatest access to private information about the company should earn the highest return. The issue of which insiders earn the highest abnormal returns is of interest to investors and regulators. We note that some market participants believe that there are differences in depth of information possessed by various insiders. Investment newsletters such as that published by the Canadian company, INK Research (Canadian newsletter), distinguish insider trades of CEOs and CFOs from those of other officers and directors. For regulators, understanding which insiders make money on insider trading is important. For example, in the U.S., the Sarbanes-Oxley Act and exchange listing requirements place an increased emphasis on outside director monitoring of listed companies (Wintoki (2007)). If the outside directors regularly profit from insider trading at the expense of outside shareholders, then questions need to be raised as to whether these outside directors can be trusted to impartially monitor management in the interest of outside shareholders. The next section of the paper reviews salient research on insider trading. The third section discusses the history of insider reporting regulation in Canada. The fourth and fifth sections describe the new Canadian dataset. The fifth section describes the empirical methodologies. The sixth section presents our empirical results and the seventh section concludes.

2. Literature Review
A number of past studies (summarized below) have attempted to estimate the returns earned by insiders by measuring the returns around purchase and sale transactions. To our knowledge, no previous study has attempted to measure the total return earned by each insider using a collection of reported trades. Jaffe (1974) estimates insiders gross abnormal profits to be 7% over ten months following intensive trading periods. Finnerty (1976) finds between 4.8% and 8.3% abnormal 3

returns over an eleven-month period. Seyhun (1986) finds cumulative abnormal returns of 3.0% over the one hundred days after insider purchases and returns of 2.5% over the one hundred days prior to sales. Eckbo and Smith (1998) find that insiders in firms on the Oslo Stock Exchange do not make abnormal profits. Jeng, Metrick and Zeckhauser (2003) use the calendar portfolio approach to measure abnormal returns for the six month window after insider purchases and sales. Using a four-factor model, they find monthly abnormal returns of 0.52% after purchases and no significant returns after sales. Past studies have provided some insight on the issue of which insiders generate the highest return. Seyhun (1986) proposes the information hierarchy hypothesis whereby the level of access to information determines how insider trading returns will vary across categories of insiders. As such, the most senior executives and senior directors should earn more than other insiders. The informational hierarchy hypothesis has been tested in several papers and the results are mixed. Lakonishok and Lee (2001) report that the predictive power of large shareholders is weaker than that of managers. They attribute this finding to large shareholders being more removed from the decision-making process of the firm. Inci, Lu and Seyhun (2010) find that the initial stock price reaction to top executives and officers trades is weaker than for large shareholders trades. Gregory, Tharyan and Tonks (2009) examine the information hierarchy hypothesis by using only two categories of British directors: executive and non-executive. They argue that executive directors are involved in the day to day management of the company, and have access to more private information than non-executives. They find some support for the information hierarchy hypothesis in that executive directors exhibit superior timing ability over non-executive directors. Two papers test but find no evidence in support of the informational hierarchy hypothesis. Fidrmuc, Goergen and Renneboog (2006) examine the trading returns of four categories of British insiders: CEOs, Chairman, top-three executives and other directors. They find that returns are no different across the categories of insiders. Betzer and Theissen (2009) study insider transactions in a sample of German companies. They categorize insiders as one of the following: CEO, other member of executive board, member of supervisory board and other. 4

Betzer and Theissen (2009) do not find any significant difference in the abnormal returns following these insider trades across the different groups of insiders. In considering the issue of who generates the highest abnormal returns, it is also useful to understand whether the abnormal returns are generated through insider buys or sells. The literature on insider trading has generally argued that buy timing should be superior to sell timing. Selling is often liquidity driven whereas buying is assumed to be information driven. Empirical studies of U.S. markets generally support this argument. Lakonishok and Lee (2001) report that insider buying has predictive ability but insider selling does not have predictive ability. The predictive ability of insiders is concentrated in smaller companies. Inci, Lu and Seyhun (2010) find that while both buying and selling insiders exhibit timing ability, the timing of insider purchases is better than that of insider sales.

3. History of Insider Regulation in Canada

3.1 The Definition of a Reporting Insider
In Canada, prior to 2009, National Instrument 55-101 specified the type of insiders who had to report their trades. These insiders included the chief executive officer, the chief operating officer, the chief financial officer and any person responsible for a principal business unit, division or function of the reporting issuer. Also included were directors of the reporting issuer, and any of the above noted senior officers or directors of a major subsidiary. A major subsidiary was defined as one with 20 percent of assets or revenues of the issuer. There was an exemption for insiders of the subsidiary who did not have access to undisclosed material information of the reporting issuer. The rules in Canada are similar to those in the United States. In the United States, insiders are defined as directors, officers and owners of more than 10 percent of any equity security of the issuer.1

Section 16 of the Securities Exchange Act of 1934.

3.2

History of Insider Equity Trading Disclosure

The Ontario Securities Act (OSA) regulates how insider trades are disclosed to the

public. Insiders must report their trades to the Ontario Securities Commission (OSC) and provide information including: their relationship to the issuer, the transaction date (not settlement date), the (average) price, the quantity of shares traded, and their total ownership after the trade. The OSA requires disclosure within 10 days following an insider trade. Before December 14th 1999, disclosure was required within 10 days of the beginning of the month following the trade. Thus, the reporting window was shortened by up to 31 days. Prior to the launch of SEDI (described below), the OSC subcontracted data entry to Micromedia Inc. The insider trading forms were sent directly to Micromedia who input them into a database. The OSC instructed Micromedia not to edit the data but record it exactly as it appeared. Since the forms were filled out by insiders, this process resulted in clerical errors which necessitates careful screening of the data as we explain in Section 4. The insider trading information is published by the OSC in the weekly Ontario Securities Commission Bulletin. In the late 1990s, plans were developed to replace the paper-based disclosure system with the Web-based system, SEDI. The goals of SEDI were to provide insiders with a means to electronically submit their trading reports and to provide the public with electronic access to insider trading data. A series of technical problems delayed the SEDI start-up until June 9, 2003. SEDI has been operational ever since.

4. Data
4.1 Data Sources and Filtering
Our insider trading data is obtained from the Micromedia and SEDI databases for the period from January 1, 1988 to Dec 31, 2006. There are 2,149,234 insider trade reports in the combined dataset: 41.6% of the data is from SEDI and 58.4% of the data is from Micromedia. The data includes reports for transactions in many types of securities: equities, bonds, warrants, rights and options. In this research we study equity trades on the public markets. The sample is summarized in Table 1. 6

[Table 1 about here] Table 1 shows that there are 746,873 observations in the combined dataset with a transaction code of 10, which indicates a purchase or sale of an equity security carried out in a public market. However, we only analyze trades in TSX listed companies and exclude trades of nonTSX listed securities. The first set of filters applied to the data is as follows. First, we include insider reports only if a ticker symbol can be assigned to the company and security type (provided by the insider on the insider trading form), only if the insider report occurred while the issue was listed on the TSX and only if the security has trading data on the Canadian Financial Markets Research Centre (CFMRC) database. In addition we use the following filters: 1) we remove all observations if the price is not positive or if the quantity is missing; and 2) we remove all corrected insider reports and all duplicate observations.2 These filters reduce the sample from 746,873 to 330,916 observations. The second set of filters is as follows. We remove insider trading reports if the reported trade date is listed as occurring after the publication date (in the OSC Bulletin or on SEDI) or if the trade date preceded the publication date by more than one year. We remove trading reports where the quantity of shares traded are greater than the number of shares outstanding. We remove all reports (from the Micromedia data) where the OSC bulletin issue or volume number is incorrect. We remove all insider trading reports if the insider is the issuing firm itself, which indicates a miscoded open market repurchase. These filters reduce the sample to its final level of 309,352 observations.

4.2

Sample Characteristics
[Table 2 about here] Table 2 shows the sample number of insider equity trading reports by year. There was an

apparent decrease in insider trading reports for 1990 and 1991. This is because the data supplied
2

Both Micromedia and SEDI include a corrections transaction code. Corrections are entered to correct an error in an

earlier insider report. In many cases it is impossible to identify whether the original or the correction is better, so all corrections and the corresponding original report are removed.

by Micromedia is not completea substantial portion of the data for the period between March 1990 and June 1991 is missing and is not available from Micromedia. [Table 3 about here] Table 3 presents a frequency distribution of the equity sample by trade direction and trade size. Trade size is divided into four levels. The levels are based around the cost of purchasing four different positions in the average company in 1998. (1998 is selected because it is in the middle of the sample and was not influenced by the technology price bubble.) For the average company in 1998, the cost of buying 1,000 shares is $11,400. The cost of buying a 10,000 block is $114,000, and the cost of buying 0.1% of the company is $436,050. Small trade sizes are defined as those costing less than $11,400. Medium are between $11,400 and $114,000. Large trades are those with a value greater than $114,000 but less than the cost of acquiring 0.1% or $436,050. Very large are worth more than $436,050. The top cut-off of 0.1% is chosen so as to maintain consistency with the literature. In particular, Fidrmuc, Goergen and Renneboog (2006) only analyze trades in excess of the top 0.1%. Table 3 shows that 54.6% of insider purchases but only 32.4% of insider sales are small. The smaller size of insider buys versus sells makes estimation of insider total returns from trade data alone difficult. [Table 4 about here] Table 4 presents a frequency distribution of the sample by trade size and relationship to get a sense of the relative importance of each insider category. We classify relationships into five categories: 1) 10% is a shareholder with at least 10% of the voting shares; 2) Inside is a director and executive who is not a 10% holder; 3) Outside is a director who is neither an executive nor a 10% holder; 4) Officer is an executive who is neither a director nor a 10% holder; and 5) Other is none of the abovegenerally a lawyer or banker affiliated with the company. Some past studies focus only on the large and very large categories, but Table 4 shows that this would overlook a great deal of potentially interesting insider trading. Very large trades are mostly the domain of 10% holders and corporate officers which is not surprising given their larger shareholdings. Other insiders are the smallest group.

5. Methodology
5.1 Abnormal Total Returns
Using insider trade data, we calculated the actual rate of return earned by each insider on their purchases and sales of shares. For each insider we calculated the total rate of return for all trades. This is analogous to a bond total return.3 The total return starts with the first transaction for the insider and ends at the last transaction. If the insider has some holdings prior to the first transaction, then we include those holdings and value them at the price prevailing on the date of the first transaction.4 If insiders hold a positive balance on the date of their last transaction, then that balance is valued at the transaction price of the last trade. Since many insiders acquire shares through stock options, option exercises are treated as purchases at the closing price on the exercise day. This assumption excludes the intrinsic value of the options from the total return calculation. This is a conservative treatment, but we regard option profits as a component of executive compensation and not as a reflection of prudent investment timing by the insider. The total return (TR) is defined as follows:
Total proceeds TR i = Total purchases
1/h

where h is the number of years in the investment horizon. Total proceeds are the future value of all sales and dividends accumulated with daily compounding at the market rate of return (S&P/TSX 300 total returns index). All quantities, prices and dividends are split adjusted. Total purchases are the present value of all purchases discounted at the market rate of return. We use market rate of return to calculate present and future values, so the market return is the assumed re-investment rate. In contrast, an internal rate of return calculation uses the solution rate as the re-investment rate. Our method biases the abnormal return calculation towards zero (since the

3 4

Fabozzi, Frank J. Bond Portfolio Management Second Edition. Hoboken: John Wiley & Sons, 2001, 358-359. Some insiders appear to sell more shares than they own due to reporting errors. We top-up the initial holdings of

those insiders.

market return is the benchmark) but the benefit is that it considerably simplifies the return calculation as compared to the internal rate of return To compute the abnormal return, the benchmark is an equivalent investment in the market portfolio. The benchmark is equivalent in timing and magnitude except that the only asset in the portfolio is the S&P/TSX 300 total returns index. The dataset of transactions starts with 38,050 insiders. We remove insiders in companies that recapitalize because it complicates the split-adjustment process. This reduces the sample to 36,292 insiders. We also remove any insider who trades only once or insiders whose holding period is less than 150 days, as their total returns can be extreme due to compounding. The resulting dataset includes 18,054 insiders.

5.2

Trade Timing Ability and Buy-and-Hold Returns

As a complement to our measure of abnormal total returns of insider, we estimate two

traditional measures of insider trade timing ability. These measures do not substitute for the total return. They are calculated over one year windows before and after purchases and sales. The first measure is the abnormal buy-and-hold return (BAHR). In functional form, the abnormal BHAR are given as: T T BHARit = (1 + Rit ) 1 (1 + RMt ) 1 t =0 t =0 where Rit and RMt are the daily returns on the sample firm and the TSX composite index for day t. The length of the holding period excludes the event day.

5.3

Trade Timing Ability and Calendar Portfolio Approach

The second measure of trade timing ability used in the literature is the calendar portfolio

approach. One reason that we might observe excess buy-and-hold returns for insiders is that the insiders earn a return to systematic risk which is not captured by the concurrent market return. In other words, any apparent abnormal gains might be due to omitted risk factors (from the returns model) such as size, earnings/price or book-to-market (e.g., Rozeff and Zaman, 1988; Lakonishok and Lee, 2001). We control for this (as much as possible) by using the calendar 10

portfolio approach with multiple risk factors following Jeng et al (2003) and Loughran and Ritter (1995). We construct four different calendar portfolios for each category of insider: 12 months before and after insider purchases and sales. Starting in January of 1988 we build a portfolio each month until the end of the sample in December of 2006. Consider the portfolio formed for twelve months after sales by outside directors. In any given month, we initiate a long position in a stock if an outside director sold shares in the preceding month. The stock is held in the portfolio for twelve months following the sale by the outside director. A new position is initiated for each sale by an outside director. If multiple outside directors from the same company all sell shares in the same month, then each sale triggers a new position. Thus, the portfolio is not equally weighted across stocks, rather it is equally weighted across insider transactions. Once a time series of portfolio returns is calculated, then abnormal returns are estimated using the following regression: R pt R ft = i + i(R Mt R ft ) + siSMBt + hiHML t + it where Rpt is the simple monthly return on the calendar time portfolio, Rft is the monthly return on three-month Treasury bills, RMt the return on the S&P/TSX composite index, SMBt is the difference in the returns of value weighted portfolios of small stocks and big stocks, HMLt is the difference in the returns of value-weighted portfolios of growth stocks and value stocks.5 The estimate of the intercept term (i) provides a test of the null hypothesis that the mean monthly excess return on the calendar portfolio is zero.

6. Analysis
This section presents results for the estimation of abnormal total return earned by insiders based on their initial holdings and their subsequent sequence of purchases and sales. As a complement to this measure, the paper presents two traditional tests of insider trade timing

This is a variation on the factors used in Fama-French (1993). Small and big stocks are bottom and top decile

companies, respectively. Value stocks are defined as all stocks with a dividend yield over 0.2% and growth stocks are all other stocks.

11

ability. The first method is the buy-and-hold return (BAHR) which measures the abnormal returns before and after purchases and sales. The second method is the calendar portfolio approach. Both of these trade timing measures may serve as a rough proxy for the actual returns earned by insiders to the extent that insiders actively trade and their holding period matches those of the measurement windows. As is discussed in the next section, these assumptions do not hold for the typical insider.

6.1

Insiders Actual Trading Patterns and Abnormal Total Returns

Table 5 presents characteristics for the 18,054 insiders with a computed total return.

Insiders hold their companys stock for approximately three years and five months on average. They trade on just over ten of those days on average, but the median insider trades on only five days.6 Insiders do more buying than selling with approximately 6 days of net buying on average (and four and one-half days of net selling). The median number of days with net selling is only one. These findings suggest that insiders are buy-and-hold investors. [Table 5 about here] The value of shares bought and sold in a day are quite similar. On average the value of an insiders daily transaction is just over a quarter of a million dollars and the median is below $30,000. While insiders are buy-and-hold, they take large-value positions.7 Much of insider activity is centered around the exercise of options and liquidation of the acquired shares. Fifty-eight percent of the insiders (10,548) acquire some shares through options. 8,341 insiders both acquire shares through the exercise of options and sell some shares. Those insiders sell 31% of the shares acquired through options on the exercise day and 39% of those shares within the week of exercise. Thus, the majority of shares acquired through the exercise of options continue to be held after the exercise date. This finding is probably due to the expiration of the options at a time when the stock is not overvalued (and so the investors are not ready to sell the shares). [Figure 1 about here]
6 7

For these statistics we net multiple trades on a single day and report net daily activity. To calculate the value of the average trade we do not net multiple trades on a single day.

12

Figure 1 presents a histogram of total returns. The median return is negative, and, the distribution is wide with very fat tails. It is surprising, given the presumed informational advantage of insiders, that a significant proportion of the sample incurs very low rates of return. A larger proportion earns extremely high returns, and, of course, the maximum return is much greater (in absolute value terms) than the minimum. [Table 6 about here] Table 6 shows the average and median abnormal total returns as well as a number of average characteristics for the sample. The average abnormal return is 1.37% and the median is 1.16%. The two-rightmost columns of Table 6 show summary statistics for top third of the sample6,018 insiders. Each of the insiders in that subset earn an abnormal return which is statistically significantly different from zero at the 1% level. The average abnormal return is 33.6% and the median is 13.3%. This group of insiders earns very large abnormal returns over a sustained time period. These returns are consistent with a large informational advantage (or with a great deal of luck!). Table 6 shows a number of characteristics of the insiders for the two samples. As we mentioned above, insiders do not trade very much. In the complete sample, the average (median) insider sells 33.1% (15.5%) of their initial holdings plus subsequent purchases. Insiders retain an average (median) of 66.9% (84.5%) of the shares they accumulate. Insiders holding period is 3.4 years on average. These results suggest that insiders are mainly buy-and-hold investors. Statistics for the top third performers are shown in the two right-most columns of Table 6. The top performers are also buy-and-hold investors. Other than their returns, the difference between the top third and the complete sample is not large. [Table 7 about here] In Table 7 we present a cross-sectional analysis of the abnormal returns and a comparison of the returns earned across various classes of insider. Table 7 presents the results for two regressions: the first employs the whole sample and compares the returns across different categories of insider relationship. The second focuses on executives only and compares the returns earned by various types of executives. Both regressions control for the following. Trade frequency: the number of trades per day during the holding period. Proportion sold: the number 13

of shares sold as a percentage of purchases plus original holdings. Holding period: the length of the holding period in days. Initial Holdings: the value of shares owned on the date of the first trade. Firm size: the market capitalization decile of the firm on the date of the insiders first trade. The analysis of the whole sample (middle column) shows that a number of the characteristics are significantly related to the abnormal returns. However, the coefficients are small and the fit of the regression is poor (the adjusted R-square is only 1.04%). As our discussion of Table 6 suggested, the variation of abnormal returns across the sample is not related to variations in the characteristics that we have proposed. The coefficients on the insider dummy variables are all statistically insignificantly different from zero except for the coefficient on Officers. This means that Officers earn a higher return on average than inside directors (the omitted dummy), and the other categories earn the same return as insider directors. In our opinion, the economic difference between the officers and the other categories is not economically of great significance. The result that Officers earn larger returns than the most informed (and at-risk) insiders, insider directors, does very little to confirm or refute either of the information hierarchy or insider liability hypotheses. The regression results for the sample of executives is qualitatively similar to the results for the whole sample. While some of the characteristics are significant, the fit of the regression is even lower. The executive position dummies for CFOs and Other Executives are statistically insignificant, which means that, on average, all executives earn the same abnormal returns on their trading. In this section we have documented that insiders are mainly buy-and-hold investors. On average they dont earn an abnormal return on their shares. We find no great differences in the average returns earned by various types of insiders not by various types of executives. However, there is a very large proportion of insiders who earn very large abnormal returns. In this research we have not identified any characteristics which distinguish these successful insiders. At this point we can only conclude that insiders who earn abnormal returns are either lucky or exceptionally smart.

14

6.2

Abnormal Returns with BAHR

Using the method described in Section 5, we calculated excess BAHR returns over a one

year window around each insiders purchases and sales. The set of trades analyzed excludes all shares acquired through option exercise and all shares sold within one week of an option exercise date. We exclude sales following option exercise (in the calculation of BAHR and calendar portfolio returns) to avoid biasing our results. Their inclusion creates a self-selection bias because options are exercised when they are in the money and options are more likely to be in the money after positive abnormal returns (rather than negative or zero abnormal returns). Thus, we would expect to see an abnormal run-up in the share price prior to the exercise of stock options (and the resulting sale of the shares). Our interest here is in measuring any timing ability that might derive from insiders asymmetric information advantage. [Table 8 about here] Table 8 presents average excess buy-and-hold returns for the one year period around purchases and sales. All of the average excess returns are significantly different from zero. There is a small average decline in prices before purchases, which suggests that insiders are contrarians and try to purchase their shares after a decline when the shares are undervalued. Unfortunately, insiders buy timing does not appear to be very good as the price continues to decline for the year after the purchase. Insiders poor buy timing is more than offset by excellent sell timing. Insiders sell after an abnormal increase of almost 35% and their sale preceded a negative return. Insiders appear to sell at the peak. These results contrast with previous research which finds that insider purchases are a predictor of abnormal returns. (See Lakonishok and Lee (2001) and Inci, Lu and Seyhun (2010).) Here we find that insider sales are a predictor of returns. We cannot explain why TSX insiders have no buy timing when U.S. insiders do. However, we offer two reasons why insiders on the TSX have better sell timing than their U.S. counterparts. First, there is evidence that insider trading enforcement on the TSX is relatively weak.8 Second, insiders on the Toronto Stock Exchange do not face the restrictions on their sales that are found in the U.S. Securities Act Rule

See Smith and McNally (2003) or King (2009).

15

144. Rule 144 requires U.S. insiders to hold restricted securities for a minimum of six months. Restricted securities includes stocks obtained through the exercise of corporate stock options. As we have seen in the Canadian sample, options are a significant source of shares for insiders. A minimum holding period would significantly reduce the timing flexibility enjoyed by U.S. insiders compared to their Canadian counterparts. The next question is whether there are differences in the returns earned by different types of insiders. We answer this question by running the following cross-sectional regression for four windows (year before purchases, year after purchases, year before sales, and year after sales): exBAHR = a0 + a110% + a2Outside + a3Officer + a4Other + a5Size + e where exBAHRit = 10% = Outside = Officer = Other = Size = the excess BAHR for insider i over the one year window for transaction j; A dummy variable taking the value of one if the insider is a 10% holder A dummy variable taking the value of one if the insider is a board member and not an officer or 10% holder A dummy variable taking the value of one if the insider is an officer (only) A dummy variable taking the value of one if the insider is not a large shareholder, director or executive. This group includes mainly lawyers and bankers. firm size decile.

The results are shown in Table 9. Firm size is included as a control variable and its coefficient is not reported. Panel A shows average excess BAHRs by relationship and Panel B shows the results for executives by job. The values in the table are the average annual excess BAHR for the indicated period (in decimal form). There are two numbers in parentheses below each average. The top value is the p-value for the significance test of the average return. The lower value is the p-value for a test of significance of the difference between the average return for that insider and the average return for inside directors (in Panel A) or CFOs (in Panel B). [Table 9 about here] The results in Panel A show that returns fall prior to purchases by inside directors but then continue to fall after the purchase. Inside director purchases do not predict a rise in share prices (over the year after the purchase). In fact none of the insider purchases, except those by officers, predict a subsequent rise in share price. Only officers exhibit advantageous timing in 16

their purchases. The pattern around insider sales is quite different. Inside directors earn an excess return that is greater than 100% in the year prior to their sales and their sales predict a subsequent decline in the stock price. The other categories of insiders exhibit the same pattern of returns around sales, although the run-up before the sales and the declines subsequent to the sales are significantly smaller in all cases. The closest category to inside directors is outside directors. Outside directors earn an excess return of more than 85% in the year prior to sales, and their sales precede a decline of almost 5% in the subsequent year. Panel B shows the results for all executives (which includes those that sit as directors) categorized by job. The Standard & Poors Industrial reports list the top executives for Canadian companies on a year-by-year basis. We used that source to identify the executive position for 5,833 of the insiders. We label CEOs, Presidents, COOs, and Chairman of the Board as CEOs. In essence, these are the bosses. We label CFOs, Treasurers or VP of Finances as CFO. These are the chief financial officers. Finally, we label all other executives as other which includes all vice presidents and senior officers. The results in Panel B show no evidence of buy timing for any of the executives: prices rise before they buy and fall (or stay flat) afterwards. As with other insiders, the timing ability of executives occurs around their sales. CEOs experience an increase of over 87% in the year before they sell and their sales precede a decline of 5.8%. CFOs experience a smaller increase before their sale and a larger decline after the sale, but the difference isnt statistically significant compared to CEOs. Other executives have a statistically significantly smaller run-up before their sales and decline afterwards. It appears that CEOs and CFOs have better timing than other executives (around sales) and that CEOs are marginally better than CFOs. All executive sales predict a subsequent decline in the stock price.

6.3

Abnormal Returns with Calendar Portfolio Approach

Table 10 shows abnormal returns using the calendar portfolio approach for the one year

period before and the one year period after purchases and sales. Separate portfolios are constructed for each insider category. The results are broadly similar to those shown in the previous section. There are no abnormal returns preceding purchases and some evidence of 17

negative returns following purchases. This indicates that there is no timing ability around purchases. The negative returns following purchases are more than offset by large positive abnormal returns preceding sales. Across all categories of insiders, the abnormal returns prior to sales are large and significantly positive. The one-year pre-sale abnormal returns range from 14.51% to 40.81%. The timing ability of insiders is further revealed by the significant negative abnormal returns in the period following sales. These findings indicate that insiders do exhibit timing ability on their sales but not on their purchases. [Table 10 about here] Panel C shows the results around sales for the five categories of relationships. The highest return before a sale is earned by outside directors. This is not consistent with the informational hierarchy hypothesis as outside directors have less knowledge than inside directors (who are also executives). The sales of directors (of both types) appear to precede the largest declines in stock prices amongst all of the insider groups. Panel D shows the results around sales across executive categories. Those results suggest that all executives have excellent sell timing, but CFOs experience a larger run-up before they sell and a larger decline after they sell. The results in panels C and D suggest that all insiders have excellent sell timing, but that directors and CFOs have the best timing.

7. Conclusions
The insider trading literature provides considerable evidence that insiders have strong trade timing ability. However, since trade timing is only one component of total return of insiders, we propose a measure of abnormal total returns that incorporates initial holdings and subsequent sequence of trades. We show that insiders are generally buy-and-hold investors in their own companies. Insiders retain an average (median) of 67% (84%) of the shares they accumulate. Over a holding period of approximately 4 years, the insiders trade on an average (median) of 10.5 (5.0) days. The high retention of stock and the relatively infrequent trading reinforce the argument that measurement of insider returns should take account of the holding period rather than just the periods of trading. 18

Our estimates suggest that, on average, insiders do not earn abnormal returns on their sequence of trades. The average insider earns a small positive abnormal return but the median insider earns a small negative return. We conclude that average insiders are generally not using their position to enrich themselves. However, the measures of central tendency mask huge variation across the sample. A very large proportion of insiders (over one third) earn very large abnormal returns (this group averages over 33%). Despite the high returns earned by some, the large majority of insiders are buy-and-hold investors: they dont trade often and they hold for a relatively long time period. We do not find strong explanatory factors for the cross-section of insider returns and can only conclude that insiders who earn abnormal returns are either lucky or unusually smart. As a supplement to the study, the paper also conducts traditional tests of trading timing ability on the data set. Contrary to previous studies, our estimates suggest that insiders buy timing is poor but that their sell timing is excellent. In absolute terms, the sell timing performance appears to more than offset the weaker insider buy timing. We attribute the excellent sell timing to the fact that the data is drawn from the Toronto Stock Exchangea market in which insider trading rules are less enforced than in the U.S. and in which insiders do not face selling restrictions like those of the U.S. Securities Act Rule 144. The lack of congruence between the apparent superior trade timing ability of insiders and the marginal abnormal total return supports the use of a more comprehensive total return measure. We also assess whether abnormal total return and trade timing ability are affected by the category of insider or type of executive. We find that no one group appears to perform significantly better (or worse) than another. We conclude that the informational hierarchy hypothesis does not describe insider trading behavior.

19

References

Barclay, M. and J. Warner. Stealth Trading and Volatility: Which Trades Move Prices? Journal of Financial Economics 34 (1993), 281-305. Betzer, A. and E. Theissen. Insider Trading and Corporate Governance: The Case of Germany. European Financial Management 15 (2009), 402-429. Bris, A., 2005, Do Insider Trading Laws Work? European Financial Management 11 (2005), 267-312. Canada, Wise Persons Committee to Review the Structure of Securities Regulation in Canada, Its Time, Ottawa, Department of Finance (2003). Cheng, S. and D. Suk. Stock Prices and the Secondary Dissemination of Information: The Wall Street Journals Insider Trading Spotlight Column. The Financial Review 33 (1998), 115-128. Fidrmuc, J., Goergen, M. and L. Renneboog. Insider Trading, News Releases, and Ownership Concentration. Journal of Finance 61 (2006), 2931-2973. Friederich, S., Gregory, A., Matako, J. and I. Tonks. Short-run Returns around the Trades of Corporate Insiders on the London Stock Exchange. European Financial Management 8 (2002), 7-30. Gregory, A., Tharyan, R. and I. Tonks. Stock Market Patterns around Directors Trades: Effects of Director Category and Gender on Market Timing. University of Exeter Business School Working Paper (2009). Inci, A., Lu, B. and H. Seyhun. Intraday Behavior of Stock Prices and Trades around Insider Trading. Financial Management 39 (2010), 323-363. Jaffe, J., Special Information and Insider Trading. Journal of Business 47 (1974), 410-428. Jeng, L.A., Metrick, A., and R. Zeckhauser. Estimating the Returns to Insider Trading: A Performance-Evaluation Perspective. The Review of Economics and Statistics, Vol. 85, No. 2 (May, 2003), 453-471. King, M. Prebid Run-ups Ahead of Canadian Takeovers: How Big is the Problem? Financial Management 38 (2009), 699-726. Lakonishok, J. and I. Lee. Are Insider Trades Informative? The Review of Financial Studies 14 (2001), 79-111. 20

McNally, W. and B. Smith. Do Insiders Play by the Rules? Canadian Public Policy 29 (2003), 125-144. Meulbroek, L. An Empirical Analysis of Illegal Insider Trading. Journal of Finance 47 (1992), 1661-1699. Seyhun, H. Insiders Profits, Costs of Trading, and Market Efficiency. Journal of Financial Economics 16 (1986), 189-212. Toronto Stock Exchange, Where Were the Directors? Guidelines for Improved Corporate Governance in Canada (The Dey Report), Toronto (1994). Wintoki, M. Sarbanes-Oxley Act and the Exchange Listing Requirements on Firm Value. Journal of Corporate Finance 13 (2007), 229-250.

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Table 1 Summary of OSC Insider Equity Trading Data 1988-2006 This table shows the evolution of the insider trading sample. The first row shows the unfiltered sample. Successive rows show the impact on the sample of various filters. The number of observations corresponds to the number of insider trading reports. The data is obtained from two sources: Micromedia and SEDI. The Micromedia data starts in January of 1988 and ends in June of 2003. SEDI data starts in January of 2000 and ends in December of 2006. Although there is a small amount of overlap, the bulk of the SEDI data is after June 9, 2003 which was the date that SEDI became fully operational. The correctness of the price and volume of the OSC insider trading reports are determined through comparison with Toronto Stock Exchange data provided in the Canadian Financial Markets Research Centre (CFMRC) database.
Sample Raw OSC Insider Trading Reports Public Stock Exchange Trades Security traded on TSX and appears in CFMRC Final Sample Nobs 2,149,234 746,873 324,766 Filter No filter. Only if transaction code #10. Code #10 indicates public market trades. If security is an equity, if security listed on TSX, if data available on CFMRC, if price > 0 and if quantity not missing. Repeats removed. Corrections deleted. Observations removed if: error in trade or publication date; shares traded greater than shares outstanding; or insider is firm itself.

309,352

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Table 2 Insider Equity Reports by Year and Source This table shows an annual break-down of the final insider trading sample. The number of observations corresponds to the number of insider trading reports of TSX-listed equity transactions (after the application of all of the filters shown in Table 1). The data is obtained from two sources: Micromedia and SEDI. The Micromedia data starts in January of 1988 and ends in June of 2003. SEDI data starts in January of 2000 and ends in December of 2006. Although there is a small amount of overlap, the bulk of the SEDI data is after June 9, 2003 which was the date that SEDI became fully operational. Insider Trading Reports Total 8,976 8,964 2,157 4,052 8,204 11,085 14,765 15,533 18,599 20,277 19,049 20,139 22,792 20,860 17,469 21,491 25,644 24,210 25,086 309,352

1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Total

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Table 3 Insider Trading Equity Reports by Trade Direction and Size Each observation is an insider trading report. Trade size is based on the average cost of purchasing four different size ranges in the average company in 1998 (mid sample). For the average company in 1998, the cost of buying 1,000 shares is $11,400. The cost of buying a 10,000 block is $114,000, and the cost of buying 0.1% of the company is $436,050. Small trade sizes are those worth less than $11,400. Medium are between $11,400 and $114,000. Large trades are those with a value greater than $114,000 but less than the cost of acquiring 0.1% or $436,050. Very large are worth more than $436,050.

Small Medium Large Very Large TOTAL

Purchases 65,000 39,563 8,951 5,427 118,941

% of total 54.6% 33.3% 7.5% 4.6% 100.0%

Sales 61,711 84,215 29,030 15,455 190,411

% of total 32.4% 44.2% 15.2% 8.1% 100.0%

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Table 4 Insider Trading Frequency by Insider Relationship and Period Trade size is based on the average cost of purchasing four different size ranges in the average company in 1998 (mid sample). For the average company in 1998, the cost of buying 1,000 shares is $11,400. The cost of buying a 10,000 block is $114,000, and the cost of buying 0.1% of the company is $436,050. Small trade sizes are those worth less than $11,400. Medium are between $11,400 and $114,000. Large trades are those with a value greater than $114,000 but less than the cost of acquiring 0.1% or $436,050. Very large are worth more than $436,050.This sample is slightly smaller than 309,352 because the relationship code is missing from some insider trading reports. 10% is a shareholder with at least 10% of the voting shares. Inside is a director and executive who is not a 10% holder. Outside is a director who is neither an executive nor a 10% holder. Officer is an executive who is neither a director nor a 10% holder. Other includes all other reporting insiders. 10% Inside Outside Officer Other Total Small 26,182 30,454 31,367 28,172 9,911 126,086 Medium 22,805 20,686 27,540 39,269 12,891 123,191 Large 9,132 5,305 5,935 13,528 3,977 37,877 Very Large 9,088 2,957 2,518 4,883 1,367 20,813 TOTAL 67,207 59,402 67,360 85,852 28,146 307,967

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Table 5 Insider Trade Characteristics This table is based on a sample of 18,054 insiders. Insiders are included if a total return is calculated. Holding Period is the number of days from first trade to last trade for each insider. Mean 1,243 10.5 5.95 4.56 26,103 29,411 $271,437 $259,231 18,054 10,548 (58.4%) 8,341 (46.2%) 31.21% 38.62% Median 860 5 3 1 4,000 4,000 $29,900 $27,423

Holding Period (Days) Number of days with trading Number of days with net buying Number of days with net selling Buy size (number of shares per purchase) Sell size (number of shares per sale) Buy value (value of shares per purchase) Sell value (value of shares per sale) Number of insiders Number (%) of insiders who exercise options Number (%) of insiders who exercise and sell Volume of shares sold on exercise day as a proportion of volume acquired through exercise Volume of shares sold in week after exercise as a proportion of volume acquired through exercise

11.76% 23.81%

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Table 6 Abnormal Total Returns Top third insiders are just the top third of the sample when ranked by abnormal total return. Sell% is number of shares sold as a percentage of purchases plus original holdings. HP is length of the holding period in days. Initial Holdings is the value of shares owned on the date of the first trade. Firm size decile ranges from 1 smallest to 10 largest. (p-values) in parentheses. * and ** indicate significance at the 5% and 1% levels, respectively.

Complete Sample of Insiders with Computed Total Returns Mean Median Abnormal Total Return Number of Trades Sell% HP (Days) Initial Holdings Firm Size Decile Numb. of Insiders 1.37%** (0.0018) 10.50 33.10% 1,243 $3,543,011 7.2 18,054 -1.16%** (<.0001) 5.00 15.51% 860 $123,752 8.0

Top Third of Insiders by Abnormal Total Returns Mean Median 33.59%** (<.0001) 9.74 35.82% 998 $3,410,808 6.8 6,018 13.30%** (<.0001) 5.00 20.13% 665 $135,000 7.0

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Table 7 Cross Sectional Analysis of Insider Abnormal Total Returns This table presents results for the following regression:
AbTR i = a 0 + a 1Freq i + a 2Sell% + a 3 HPi + a 4 Hold i + a 5Size i + a j D ji + i
j=6 n

AbTR is abnormal total return. Freq is number of trades per day during the holding period. Sell% is number of shares sold as a percentage of purchases plus original holdings. HP is length of the holding period in days. Hold is logarithm of the value of shares owned on the date of the first trade. Size is size decile of firm. Dj represents a set of dummies for the following classes of insiders. 10% is a shareholder with at least 10% of the voting shares. Outside is a director who is neither an executive nor a 10% holder. Officer is an executive who is neither a director nor a 10% holder. Other is all other reporting insiders. CFO includes CFOs, VP-Finance, treasurers. Other Exec includes all other executives. (p-values) * and ** indicate significance at the 1% and 0.1% levels, respectively.
Variable Intercept Freq Sell% HP Hold Size 10% Outside Officer Other CFO Other Exec Nobs Adj R 17,898 1.04% All Insiders 10.14%** (<0.001) 92.84** (<.0001) 6.23** (<.0001) -0.90** (<.0001) -0.34 (0.0514) -1.40** (<.0001) 3.71 (0.0823) 3.76 (0.0135) 4.88** (0.001) 3.24 (0.0704) Executives Only 11.07%* (0.0012) -54.81 (0.1777) 4.66 (0.0079) -0.58* (0.0020) -0.37 (0.1260) -1.06** (<.0001)

0.46 (0.8141) 2.50 (0.0707) 5,833 0.65%

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Table 8 BAHR Before/After Insider Purchases and Sales Abnormal buy-and-hold returns estimated over one year periods before and after insider purchases and sales. Option exercises are not included. Sales within one week of an option exercise date are excluded and all trades involving stocks whose price is less than $1 are excluded. (p-values) in parentheses. * and ** indicate significance at the 5% and 1% levels, respectively. Means are trimmed with 1% removed from each tail. Window Pre-Buy Post Buy Pre Sell Post Sell Mean Abnormal BAHR -0.0128** (<.0001) -0.0435** (<.0001) 0.3496** (<.0001) -0.0731** (<.0001)

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Table 9 BAHR Before/After Insider Purchases and Sales All returns are annual expressed in decimal form. Estimation period is one year prior to or following purchase or sale. Inside is a director and executive. 10% is a shareholder with at least 10% of the voting shares. Outside is a director who is neither an executive nor a 10% holder. Officer is an executive who is neither a director nor a 10% holder. Other (Panel A) is all other reporting insiders. CEO includes CEOs, presidents, board chairs. CFO includes CFOs, VPFinance, treasurers. Other (Panel B) includes all other executives. Option exercises are not included. Sales within one week of an option exercise date are excluded and all trades involving stocks whose price is less than $1 are excluded. exBAHR = a0 + a110% + a2Outside + a3Officer + a4Other + a5Size + e There are two (p-values) in parentheses below each coefficient estimate. The top p-value refers to a test of significance for the coefficient and the bottom p-value refers to a test of the difference between the coefficient for that category of insider and the coefficient for the Inside Director (Panel A) and CEO (Panel B). Variable Pre-Buy Post-Buy Pre-Sell Post-Sell PANEL A: Average Excess BAHR for Insiders by Relationship Inside -0.0835 -0.0925 1.0659 -0.0968 (<.0001) (<.0001) (<.0001) (<.0001) 10% -0.0073 -0.0598 0.6443 -0.0327 (0.5503) (<.0001) (<.0001) (0.0010) (<.0001) (<.0001) (<.0001) (<.0001) Outside -0.0340 -0.0311 0.8652 -0.0487 (0.0138) (0.0006) (<.0001) (<.0001) (0.0072) (<.0001) (0.0073) (<.0001) Officer -0.0481 0.0348 0.5234 -0.0212 (0.0011) (0.0018) (<.0001) (0.0360) (0.0642) (<.0001) (<.0001) (<.0001) Other -0.1309 -0.0116 0.4142 -0.0160 (<.0001) (0.3047) (<.0001) (0.1535) (0.0188) (<.0001) (<.0001) (<.0001) PANEL B: Average Excess BAHR for Executives by Job CEO 0.0633 -0.0503 0.8770 -0.0584 (0.0002) (<.0001) (<.0001) (<.0001) CFO 0.0394 -0.0149 0.7547 -0.0777 (0.0548) (0.3379) (<.0001) (<.0001) (0.3669) (0.0343) (0.1941) (0.0905) Other 0.0518 0.0169 0.5714 -0.0374 (0.0020) (0.0413) (<.0001) (<.0001) (0.6226) (<0.0001) (0.0004) (0.0106) 30

Table 10 Calendar Portfolio Alphas Before/After Insider Purchases and Sales Portfolio holding period is one year prior to or following purchase or sale. R pt R ft = + 1(R Mt R ft ) + 2 * SMBt + 3 * HML t + t Rpt is the monthly return on the calendar time portfolio, Rft is the monthly return on three-month Treasury bills, RMt the return on the S&P/TSX composite index, SMBt is the difference in the returns of value weighted portfolios of small stocks and large stocks, HMLt is the difference in the returns of value-weighted portfolios of growth stocks and value stocks. This regression is run on the time series of monthly returns for 32 different portfolios: before and after the purchases and sales for the following eight categories of insiders. Inside is a director and executive. 10% is a shareholder with at least 10% of the voting shares. Outside is a director who is neither an executive nor a 10% holder. Officer is an executive who is neither a director nor a 10% holder. Other is all other reporting insiders. CEO includes CEOs, presidents, board chairs. CFO includes CFOs, VP-Finance, treasurers. Other Exec includes all other executives. The coefficients for the risk variables are not reported. Option exercises are not included. Sales within one week of an option exercise date are excluded and all trades involving stocks whose price is less than $1 are excluded. (p-values) in parentheses. * and ** indicate significance at the 5% and 1% levels, respectively. Before After Insider Alpha p-value Alpha p-value Panel A: Purchases By Relationship 10% 4.75% 0.1774 -10.69%** <.0001 ** Inside -4.91 0.1415 -11.52 0.0013 Outside -0.25 0.9157 -7.58** 0.0026 Officers 2.66 0.2358 1.04 0.6460 ** Other -0.56 0.8552 -8.38 0.0063 Panel B: Purchases By Executive Position CEO -2.23 0.5253 -9.06** 0.0016 CFO 3.70 0.5544 -11.11* 0.0245 Other Exec 3.51 0.3008 -3.12 0.3196 Panel C: Sales By Relationship 10% 21.78* 0.0119 -10.66** 0.0074 ** ** Inside 38.26 <.0001 -15.57 <.0001 Outside 40.81** <.0001 -13.99** <.0001 ** ** Officers 22.70 <.0001 -6.21 0.0008 Other 14.51** 0.0001 -8.86** 0.0002 Panel D: Sales By Executive Position CEO 19.62** 0.0002 -10.26** 0.0004 ** ** CFO 35.03 <.0001 -15.44 0.0002 ** Other Exec 28.89 <.0001 -5.06 0.0853 31

Figure 1 Histogram of Abnormal Total Returns This table is based on a sample of 18,054 insiders. Insiders are included if a total return is calculated.

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